Capital Group Holds Fast to Fund Approach

Most mutual fund companies would be thrilled with the kind of attention that Los Angeles-based Capital Group Cos. has attracted of late.

Its stock and bond funds were the nation’s most popular by far last year, taking in $66 billion in new cash, nearly twice as much as the next-best-seller, Vanguard Group. All of Capital’s stock funds, marketed under the American Funds label, posted net gains in the five years through February, a period that included the worst bear market in a generation.

A just-published book on the company, written by investment management consultant Charles Ellis, begins with this declaration: “No investment organization in the world has ever done so well for so long, for so many clients, as Capital Group.”

All of this comes at a time when much of the fund industry stands accused of participating in various kickback schemes to boost sales and profit at the expense of small shareholders. Capital, like dozens of other fund firms, is being examined by both state and federal regulators. But no wrongdoing has been alleged, and the company has defended its practices as proper.

So far, the scandal has even been good for Capital: It is winning new business as investors switch to its funds from tainted rivals.

Yet on the top floors of the BP Plaza building downtown, where the $840-billion Capital empire is headquartered, executives of the third-largest U.S. fund firm have no interest in the limelight. In fact, they tend to treat publicity like a virus: It’s best to avoid it.

Capital’s attitude toward self-promotion is best summed up in a line used by its 77-year-old leader, Jon Lovelace, the son of the founder and guiding hand of the business for four decades: “Nothing wilts faster than laurels rested upon.”

Indeed, despite all the recent success, Capital executives say they are keenly aware of just how fickle the market can be.

“We know it’s a cyclical business,” said Paul Haaga, executive vice president of Capital Research & Management, the Capital Group unit that oversees the firm’s mutual funds. As recently as the late 1990s, Capital’s conservatively managed funds fell out of favor for a few years as many people turned to more speculative investments that promised stratospheric returns.

In an interview with The Times last week, Haaga, 55, and James Rothenberg, the 57-year-old president of the funds unit, said the company naturally worried that the record sums flowing into its funds could quickly reverse if new investors were to sour suddenly on the stock market overall or on Capital’s “value”-oriented investment style.

“All of this money -- we don’t know what its stability will be,” Rothenberg said.

Meanwhile, the company faces questions stemming from its reliance on brokers to sell its funds. Specifically, regulators are looking into so-called pay-to-play deals -- agreements by which particular funds enjoy a higher profile with a brokerage’s sales force if the fund company agrees to make certain compensating payments beyond the standard brokerage commission.

State Atty. Gen. Bill Lockyer in January subpoenaed Capital and two other big California-based fund companies, Pimco Funds and Franklin Resources Inc., in a probe of such arrangements. Capital says it’s cooperating.

For the company, the long-term worry about its extensive use of brokers may not be Lockyer’s inquiry but aging investors.

Unlike the No. 1 and No. 2 U.S. fund companies, Fidelity Investments and Vanguard, Capital doesn’t sell directly to individuals except through company retirement plans. It conducts no mass-market advertising. Rather, it relies on middlemen to tout its funds -- and to keep those clients from bolting to other investments.

As longtime investors die off, that may become more difficult. Their money will be passed on to children or other beneficiaries who may never have heard of American Funds. This new generation could be more inclined to put its cash in a better-known brand.

For the moment, however, Capital’s biggest challenge is the opposite: how to handle all the new money gushing in.

Capital has just 29 funds in all, compared with about 180 at Fidelity. This means that a lot of cash is being concentrated in a small number of portfolios. Historically for the industry, this is a recipe for trouble: Huge funds often have difficulty outperforming the market.

But not Capital.

“Despite the amount of money coming in, their performance continues to be extraordinary,” said Avi Nachmany, research chief at fund consulting firm Strategic Insight in New York.

In part, that’s because of the type of stocks Capital buys: mostly big, dividend-paying blue-chip shares. Rothenberg estimated that the firm’s team of analysts around the globe, widely considered to be among the best research operations in the business, covers only about half of the world’s largest companies. The upshot is that there are potentially a lot of good ideas for Capital yet to discover.

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‘Multiple Counselors’

The company’s ability to handle huge sums in individual funds also is a function of the “multiple counselor” system that Lovelace created in 1958. The concept was to divide each portfolio into half a dozen or so slices, each run by an individual manager who would be expected to share ideas with his peers but would have total discretion over his slice of the pie.

Although the potential for managers’ stock choices to be at odds with one another is ever present, Capital’s long-term fund performance results are proof that the system has worked, Ellis said. The advantage is that as more money comes into a fund, the company can carve out more slices rather than risk overloading current managers, he explained.

Growth Fund of America, the company’s largest mutual fund, at $73 billion, illustrates the multiple-counselor system in action. Six individuals, including Rothenberg, manage slices of the portfolio. The fund has produced an average annual return of 15.7% since Dec. 1, 1973 (when Capital began running it), trouncing the 12.2% average return of the blue-chip Standard & Poor’s 500 index in the same period.

Capital’s philosophy has never been to shoot the lights out with its results in any one year. What the firm sells is consistency of returns and, most important, a risk-averse approach that aims to limit investors’ losses in down markets.

“They are one of the few fund firms that has a clear sense of who they are and what they do,” said Neil Bathon, president of Boston-based Financial Research Corp., a fund data company.

For the Capital system to work, however, its managers must have the luxury of being able to stick with their convictions. In turn, the funds’ investors must adhere to a long-term, buy-and-hold philosophy.

Throughout its history, Capital has maintained that the best way to get and keep the kind of investors it wants is to sell its funds through brokers and other financial advisors rather than to do-it-yourselfers. The broker is supposed to pitch investors on the Capital approach, then keep them on that path through good markets and bad.

This decades-old strategy continues to work, Rothenberg said: The redemption rate of Capital funds -- the percentage of assets cashed out each year -- is half the rate of the fund industry as a whole.

Mark Elliott, a financial consultant at brokerage RBC Dain Rauscher in Pasadena, says he has been putting clients into Capital’s mutual funds for 15 years.

“For a core, conservative holding there is no better family,” he said. “If you want something sexy, that’s not their strength.”

Elliott says he believes Capital always keeps investors’ best interests at heart. He points to the funds’ below-average management expenses (the fees charged for running a portfolio) and the firm’s long-standing resistance to rolling out trendy funds in hot sectors -- think Internet stocks -- just to make another sale.

What’s more, Elliott likes the attention the fund pays to him in getting the Capital story out. He has dealt with the same Capital fund wholesaler for years. “He gives me the inside story” on market and fund trends, Elliott said.

Each month, Capital also distributes videodiscs in which analysts and portfolio managers chew over investment themes and economic issues. It holds two-day conferences for brokers at the firm’s offices each year. Along with presentations from fund managers and analysts, those sessions have featured motivational speakers such as former UCLA basketball coach John Wooden.

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‘Goodwill With Brokers’

Capital “has curried a lot of favor and goodwill with brokers because they treat them like professionals,” said Geoff Bobroff, who heads fund research firm Bobroff Consultants in East Greenwich, R.I.

Still, the specter of scandal hangs out there, as federal regulators continue to look into pay-to-play arrangements involving more than a dozen fund companies, including Capital.

On its website, Capital has laid out why it pays brokerage firms, and how much. The firm says such revenue sharing helps to cover costs of educating brokers about the funds. The annual payments -- a maximum of 0.10% of a brokerage’s total sales of Capital’s funds during the previous year, and 0.02% of total Capital fund assets at the brokerage -- are borne by Capital, not by its funds.

Nonetheless, critics say the practice raises the risk that brokers will sell funds that are inappropriate for an investor’s needs, just because revenue sharing is involved.

Analysts say it’s far from clear that authorities could charge fund companies with wrongdoing, because revenue-sharing agreements have been common knowledge among regulators for years.

“I think the next phase of this is just going to be more disclosure” on the part of the funds and brokers, said Financial Research’s Bathon.

For Capital, the bigger issue with its broker relationships may be whether the firm can count on those selling its funds in this decade to keep clients on board, as their predecessors have done for so long.

Rothenberg concedes that it’s an open question.

“With a lot of the younger brokers, we don’t know a lot about those people yet,” he said.

But Haaga said the firm expected that if it can continue delivering consistent performance while limiting portfolio losses, “the demographics are on our side.”

As aging baby boomers confront retirement, Haaga said, “we think that audience is going to be much less interested in quick pops and much more interested in stability and income.”

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Fund performance: a sampling

Here are the best-selling American Funds in 2003, and their performance data.

*--* Assets Total returns: Fund (billions) 2003 10 years * Growth Fund of America $74 32.9% 13.5% Capital Income Builder $28 21.6% 10.8% Income Fund of America $42 25.3% 10.5% American Balanced $32 22.8% 11.2% Washington Mutual $67 25.8% 12.5% S&P; 500 index $28.7 11.1%

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Returns are before sales charge.

* annualized

Sources: American Funds, Financial Research Corp.